Thursday, June 20, 2013

Face off: Schannep versus “classical” Dow Theory

Part I. Delineating
the object of our study

It is no
secret that this blogger truly yours has always passionately defended
Schannep’s Dow Theory “flavor." For the uninitiated, it suffices to say
that the Dow Theory is not monolithic and, hence, different variations of a
common theme cohabit in hopefully peaceful harmony. More about the different
Dow Theory flavors here.

Classical Dow
Theorists are very adamant about any changes of the Dow Theory as was expounded
by Rhea, and, in my opinion, due to a lack of understanding of Schannep’s
flavor tend to dismiss any improvement of the Dow Theory as heretical or
defective.

However, I
have always contended that Schannep’s rules make full aprioristic and empirical
sense. To learn more about Schannep’s flavor of the Dow Theory and Rhea, please
gohere.

To put it succinctly,
three different ways of investing coexist under the name “Dow Theory," Theory”,
namely:

1.One
based on the secular trend, lasting the secular trend 10 or more years.
Positions taken along the secular trend can last even a decade and good values
(i.e high dividend yield) are paramount to establish a long position. At the
risk of oversimplifying this is the way Charles Dow and Schaefer advocated.

2.One
based on spotting cyclical bull and bear markets irrespective of value
considerations. While the writings of Charles Dow contain hints as to this kind
of investing, Dow’s understudy Hamilton, and finally Rhea are the ones that
really developed the rules pertaining to this specific kind of trend following.
Most market practitioners agree that the Rhea version of the Dow Theory is the
“classic” one.

3.Schannep
on the footsteps of Rhea produced a more updated and responsive Dow Theory “flavor.", which is essentially Rhea's Dow Theory with steroids.
This is the Dow Theory “flavor” which is followed by this blogger truly yours.

Well, actually,
Schannep’s goes beyond tweaking the Rhea/classic Dow Theory. While the backbone
of Schanneps’ timing system is the Dow Theory (as improved by him), he avails
himself of other “tools” to improve his market calls. Thus, Schannep’s timing
system is made of:

1.First
of all, the Dow Theory. I’d confidently say that 90% of his buy and sell
signals are based on the Dow Theory (which is pure trend following).

2.5%
or so of the buy and sell signals is Schannep’s bull and bear market definition,
namely a decline of -16% for a bear market and a rally of +19% for a bull market.
While many Dow Theory buy and sell signals overlap Schannep’s bull and bear
market definition, in some rare instances the market makes such powerful movements before a Dow Theory signal is flashed (here you can read more about
Schannep’s bull and bear market definition). In any instance, taking buy and
sell signals based on previous advances or declines is without any shade of
doubt trend following. Schannep’s website “thedowtheory.com” contains the list
of bull and bear markets according to this definition.

3.The
remainder is a buy-only signal, the so-called “capitulation." When markets
experience a dramatic decline (as measured by Schannep’s proprietary
indicators), investors are advised to exceptionally deviate from trend
following and, instead, bet for a trend reversal. In other words, when the
market is severely oversold, buy and expect a new bull market soon. Of course,
this is not trend following but, rather, mean reversal trading, which is in the
antipodes conceptually of trend following. However, Schannep’s capitulation
indicator (more about it here) has served him well in the past.

4.In
addition to the three “tools” I have just mentioned, Schannep’s toolbox
contains a final tool: The “timing indicator," which is proprietary,
although Schannep discloses a good deal of its entrails here.

Schannep’s“timing indicator” is a final source
from which to derive buy and sell signals. Most of the time, the “timing
indicator” is closely aligned with the Dow Theory or the bull and bear market
definition. However, in some occasions, the “timing indicator” serves to increase
responsiveness to trends and to avoid whipsaws.

Therefore, it is very important to make a rigorous
comparison of the “Rhea/classical” Dow Theory with Schannep’s. After all, we
shouldn’t get blinded by Schannep’s outperformance of ca. 2% versus the “Rhea/classical” Dow Theory.
If such outperformance was achieved with deeper drawdowns or with an extremely
high turnover (and its attendant commissions and slippage), then we would be
better advised to stick to the traditional Dow Theory, which is a great timing
system in and of itself. Thus, I set out to study Schannep’s performance and
transactions from all possible angles. I will leave no stone unturned.

However, I want to make an apple to apples comparison.
If I am going to compare Schannep’s Dow Theory flavor with the “classical
Rhea”, I feel I cannot take the full corpus
of Schannep’s tools, since some of these tools, in spite of their
effectiveness, have nothing to do with the Dow Theory.

Accordingly, before I proceed to compare Schannep’s
Dow Theory flavor with the “Rhea/classical” one, I am going to somewhat trim
Schannep’s system.

First of all, I will get rid of the “capitulation”
rule. As I said above, the capitulation rule suggests the opening of a long
position when the market is severely oversold. It is catching the proverbial
“falling knife." Thus, this indicator, although effective, has been
ignored in the calculations I have made. An oscillator by its nature (mean
reversal) is in the antipodes of any trend following method (among which is the
Dow Theory).

Secondly, I won’t use the Schannep’s “timing
indicator” because of two reasons: (a) In the first place, because the
indicator integrates fundamental data such as monetary policy in addition to
pure momentum (trend following) elements; (b) last but not least because its
composition has not been fully disclosed to the public, and I cannot test what
I don’t fully know.

On the other hand, I will integrate Schannep’s
definition of bull and bear markets (+19 and -16% movements, respectively)
because this is pure trend following. This is the essence of any breakout,
momentum based system, and, hence, it bodes well with the Dow Theory. In any
instance, there were only 1 buy and 1 sell signal based upon this rule during
the time period studied (which spans almost 60 years) out of a total of 31 round trades.

Curiously enough my “trimming” of Schannep’s
sophisticated machinery didn’t result in a significant deterioration of performance.
This attests to the robustness of Schannep’s Dow Theory rules. In other words,
Schannep’s Dow Theory rules don’t need the crutch of other indicators to excel
and outperform the Rhea/Classical Dow Theory. This is not to downplay the
importance of the capitulation and the “timing indicator” because they are the
icing on the cake, and add value (more than in raw performance by smoothing signals
and enable the transitioning from a full invested to a partially invested
position and vice versa). However, since the “Rhea/classical” Dow Theory record
doesn’t contain any of these indicators, the proper way to compare Schannep’s
interpretation of the Dow Theory is by reducing his system to just the Dow
Theory, and the bull/bear market definition of +16 and -19% market movement
respectively.

Bearing in mind the preceding considerations, I am
confident that I have conducted a real "apple to apples” comparison. I
have really compared two trend following systems of a very similar nature.

In the coming posts, we will compare both “flavors”
from the following angles:

·Total performance.

·Trade duration.

·Time in the market.

·Profit factor.

·Percentage of winning trades.

·Average winning trade.

·Average losing trade.

·Largest losing trade.

·Win to lose ratio.

·Profit factor.

·Total performance in secular bull
markets

·Total performance in secular bear
markets.

·And much more…

Well, now is time to put an end to this lengthy post. Those
thirsting for “data” should wait for the next post, which I hope to post next weekend. However, since this is a
serious attempt to analyse both Schannep’s and the “Rhea/classical” Dow Theory,
it was necessary to clarify our premises and the object of our study. To begin with, it suffices to say that Schannep's Dow Theory "flavor" excels
on all counts. My conviction regarding the importance of Schannep’s contribution
to the art of market timing has been further cemented after having performed
this in-depth study.

About Me

Disclaimer/Disclosure

This blog (dowtheoryinvestment.com) is strictly a personal journal applying my interpretation of Dow Theory principles to the action of the stock market and my musings about investment and trading in general. This blog is intended solely for entertaining, illustrative or informational purposes. I am not a registered investment advisor and neither the information nor the opinions expressed should be construed as a solicitation to buy or sell any stock, option, ETF, mutual fund, currency, commodity, or any other security. I am unaware of any readers personal circumstance, financial condition, risk tolerance or goals and objectives, so nothing read here should be considered advice suitable for them. Anyone reading this blog does so with the understanding that this is strictly meant as an analytical exercise and does not proffer actionable advice in any way, shape or form. Trading and investing always entail risk and possible loss of funds and should only be undertaken after appropriate due diligence by the trader/investor and after consulting a registered investment adviser.